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How Is Food Deflation Affecting the Restaurant and Food Retail Industry?

Supermarkets are in the midst of a price war, and restaurant sales are sliding.

You may not know it, but food prices have plummeted over the past year.

Staples including eggs, dairy, and beef are down sharply. Egg prices, which spiked last year due to an avian flu outbreak, have fallen as flocks have recovered. The U.S. Department of Agriculture now expects consumer-level egg prices to be down 18%-19% for the year.

Prices for commodities including beef, dairy, pork, and poultry are projected to drop between 1% and 5% for the year.

That deflationary effect has been a boon for consumers, who are saving money every time they shop at their local supermarket, but it's been a challenge for grocery stores and restaurants alike.

For supermarkets, food deflation has resulted in a price war, crimping sales and profits. Meanwhile, restaurant chains are reporting slower traffic as consumers take advantage of lower prices to eat at home more often. Food deflation is one of many factors that has led to a so-called restaurant recession.

Slashing guidance

Several supermarket chains warned that sales growth would be stunted this year. In September, SUPERVALU (NYSE:SVU) noted that retail sales were softer than expected, citing "deeper levels of deflation." This week, the company reported comparable sales falling more than 5% in its second quarter.

Also in September, Kroger (NYSE:KR), the nation's largest grocery chain, lowered its adjusted full-year EPS guidance to $2.10-$2.20 from $2.19-$2.28, noting "continued deflation." Sprouts Farmers Market (NASDAQ:SFM) echoed its peers, cutting its full-year guidance in September due to deflation, and also noted a stepped-up promotional environment. All three stocks are now trading near 52-week lows.

There's evidence that the deflationary environment is favoring larger operators like Kroger, which said it gained market share in its most recent quarter, and Wal-Mart (NYSE:WMT), which posted its strongest comparable sales growth in several years in its most recent report. Wal-Mart does not break out sales by category, but a majority of its sales come from grocery, and it is the biggest grocery retailer in the country. The big-box giant has been focused on lowering prices and cleaning up stores in recent quarters, and the strategy appears to be bearing results. For competitors like Wal-Mart and Kroger, lowering prices to gain market share during deflationary periods is a smart strategy as they will tend to keep those new customers when prices rise.

Is the restaurant recession for real?

Generally, restaurants and supermarkets compete over sales, meaning a gain for one is usually a loss for the other. But in recent months, both restaurants and supermarkets have been seeing sales growth slide. With labor costs spiking due to increases in state-level minimum wages, higher healthcare costs, and a tighter labor market, restaurants have been reluctant to lower prices even as food costs go down.

A number of restaurant chains have issued weak guidance lately. Sonic (NASDAQ:SONC) caused a sell-off across the industry when it reported a surprise drop in comparable sales in preliminary fourth-quarter results, with a 3% slide at company-owned locations and a 1.8% drop at franchised stores.

Indeed, same-store sales at restaurants have fallen for five months in a row, but the correlation between food deflation and weak sales isn't so clear. According the U.S. Census Bureau, overall sales at food and drinking places have increased 6.4% this year, compared to 2.1% at grocery stores. In September, overall restaurant sales were up nearly 8%.

That could indicate that sluggish comparable sales are being caused instead by a glut of restaurants. There's evidence of that in a number of recent bankruptcy filings, including Cosi; Don Pablo's parent, Rita Restaurant; and Garden Fresh, which owns Souplantation and Sweet Tomatoes. Several other operators have announced closings, including Ruby Tuesday and Bob Evans Farms, and just this week BJ's Restaurants said it would slow down its pace of expansion due in part to weak comps. Perhaps the bankruptcies and closures are not a surprise, considering the rash of fast casual chains that have come on the market in recent years, promising to expand to thousands of locations.

Food deflation may be one factor in the mix, as the gap between restaurant and grocery prices is significantly wider than its historical average, but it's likely one of many. Some restaurants have even blamed anxiety over the upcoming election for the poor results.

Still, if food deflation is the culprit, that's likely to change next year as the Department of Agriculture is projecting modest increases in food prices across most categories. This forecast is subject to change depending on weather, disease, and other factors, but it should offer some reassurance to supermarket and restaurant investors who have seen their holdings slide recently.

Jeremy Bowman owns shares of Kroger. The Motley Fool owns shares of Bob Evans Farms. The Motley Fool recommends BJ's Restaurants. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Fool since 2011. I write about consumer goods, the big picture, and whatever else piques my interest. Follow me on Twitter to see my latest articles, and for commentary on hot topics in retail and the broad market.
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